Fiscal cliff could be worse than many think

Fortune — The fiscal cliff could push us into recession, and the fall could happen sooner than many think. At least that’s the view of Bank of America’s top U.S. economist Ethan Harris.

Most economists have been focused on the direct impact the series of tax increases and government spending cuts scheduled to kick in January 1 could have on the economy. Last month, the Congressional Budget Office warned the fiscal cliff could cause GDP to shrink 1.3% in the first half of 2013. Many economists, though, believe Washington will eventually cut a deal to put off the worst of the blow. Others say effects of the tax increases and spending cuts could take months to kick in. As a result, many have concluded the fiscal cliff could be little more than a bump.

Harris disagrees, and says others are missing the point. He believes shock of the fiscal cliff will hit the economy long before we reach the theoretical edge. He says corporate earnings growth will slow in the second half of the year, job growth could drop to near zero by October and that we may be headed to another recession.

“If you are running a business, why would you commit to hiring a person or spending money if you know that there’s a pretty good chance the fiscal cliff could cause a recession,” says Harris. “In terms of uncertainty and confidence, this is last summer times four.”

Harris has been worth listening to. He has long done a better job of predicting the economy than his peers, and this year has been no exception. Harris started the year with the lowest estimate for GDP growth for the second half of the year of any economist at a major Wall Street firm. At the time, the economy was improving, and many economists were predicting a sustained pick up in growth. Harris, though, said it was temporary, and that we might be headed for a “triple dip,” on the order of what we saw last summer. A recession in Europe was sure slow the U.S. economy by mid-year. That’s mostly how things have played out. The consensus on the Street is that the U.S. economy will grow 2.3% this year, which is now nearly in line with Harris’ 1.9% prediction.

Surprisingly, Harris now sees the economy slightly improving for the next couple of months. The mild-winter pulled spring hiring forward in the year. That’s led to the recent weak job numbers. Harris says the weather effect is now fading. What’s more, he thinks Europe’s drag on the U.S. won’t get any worse. Combined, he points out, Europe has less of a debt problem than the U.S. Unlike the U.S., though, the debt is not centralized. Still, to Harris, Europe’s relative debt level means its problems are manageable.

But Harris says Europe was only half of his reason for his downbeat forecast. The other is the fiscal cliff. He says, unless Washington strikes a deal to roll back some of the cuts soon, it almost doesn’t matter if we avoid the fiscal cliff or not. Put a range of options on the table in front of a CEO and if at least one of them is recession, he is going to act with caution. The closer we get to January 1, the more cautious CEOs will become. By the time Washington reaches a deal, which many guess might not happen until after the election, the economy is likely to have already stalled.

Will that lead to another recession? Harris says probably not, though he does think that it’s a strong possibility. He says by year-end the Federal Reserve will come in with a new stimulus program, perhaps QE3, large enough to keep the economy from going south. And he is hopeful that Washington will eventually, if too late, roll back some of next year’s tax increases and spending cuts. Still, he believes a prolonged fight about the fiscal cliff will further weaken most Americans’ faith in the U.S. government, which will continue to be a drag on the economy. All this will make the already anemic recovery drag out that much longer. Even next year, Harris believes the U.S. economy will grow by an anemic 1.4% next year, and that it might not be until mid-2015 before the Fed raises interest rates. Worse, Harris says, is the fact that Wall Street still doesn’t see the problems of the fiscal cliff coming.

“The expectation is that growth is going to pick up in the second half, and I think it’s likely the economy could be flat or down,” says Harris. “Why would earnings pick up at the year end. It doesn’t make any sense.”